Thursday, May 06, 2010

A Step Towards Clarity on the Invisible Hand

Stephen LeRoy, professor emeritus at the University of California, Santa Barbara and fellow of the Reserve Bank of California, writes in the FRBSF Economic LetterHERE

Is the “Invisible Hand” Still Relevant?

The single most important proposition in economic theory, first stated by Adam Smith, is that competitive markets do a good job allocating resources. Vilfredo Pareto’s later formulation was more precise than Smith’s, and also highlighted the dependence of Smith’s proposition on assumptions that may not be satisfied in the real world. The financial crisis has spurred a debate about the proper balance between markets and government and prompted some scholars to question whether the conditions assumed by Smith and Pareto are accurate for modern economies.

The single most important proposition in economic theory is that, by and large, competitive markets that are relatively, but generally not completely, free of government guidance do a better job allocating resources than occurs when governments play a dominant role. This proposition was first clearly formulated by Adam Smith in his classic Wealth of Nations. Except for some extreme supporters of free markets, today the preference for private markets is not an absolute. Almost everyone acknowledges that some functions, such as contract enforcement, cannot readily be delegated to market participants. The question is when and to what extent—not whether—private markets fail and therefore must be supplanted or regulated by government.

CommentThis is a sensible and timely article on an important economic issue provided that readers ignore the headline, which has nothing to do with its content. It doesn’t mention the invisible hand again, so, presumably it is the work of a sub-editor and not that of the author.

In fact it follows a line of argument that Paul Samuelson wrongly cast ad being about Adam Smith’s invisible hand. Samuelson linked the invisible hand directly to Pareto Optimality and Arrow and Debreu’s formulation of the General Equilibrium thesis. Stephen LeRoy casts Pareto and Debreu’s mathematical ‘proof’ of competitive markets as an alternative to Adam Smith’s views on competitive markets (sans the invisible hand).

The difference between this approach and Samuelson’s is instructive. In retrospect, if Samuelson had confined himself to LeRoy’s approach it would have saved the entire economics profession from raising the invisible hand from only being a ‘more striking and interesting’ metaphor to that of an invented ‘doctrine’, ‘theory’, ‘idea’, even ‘paradigm’, now ubiquitous in discourse of former students of economics in the last 6o years, in the upper reaches of government, public service, media opinion formers, legislators and those who influence them.

Despite what Adam Smith says in his Wealth Of Nations about the use of the metaphor of an invisible hand, most economists (though there are signs now of dissent appearing among some of them – Stiglitz for instance) do not even read the objects of the many metaphors that Smith used in his books. They leap to the conclusion that the invisible hand for him was about markets. It certainly is believed to mean that for most economists since the 1950s.

In both examples, once in Moral Sentiments and once in Wealth Of Nations, the context was definitely not about competitive markets. There was nothing competitive about life for labourers and their families in the quasi-feudal regimes of ‘Rich landlords’ (TMS IV.ii: 184-85), nor for merchants in 18th-century mercantile Britain (WN IV.ii.9: 456).

Neither circumstance was driven by market considerations: the landlords had no choice but to feed their serfs out of their grain stores if they were to be fit to labour for them on the land each season and survive the winters each year, and the merchants who chose to invest locally were led by their insecurity over sending their capital abroad, hence the preferred to stay at home within their sight and control. Necessity led landlords to supply food to their labourers and the insecurity of merchants led them to invest locally. These were the objects of the metaphor of ‘an invisible hand’.

The metaphor of an invisible hand expressed his descriptions of these considerations in a ‘more striking and interesting manner’, as Smith put it in his lectures on metaphors in his Rhetoric (1763-63; 1983: 29).

As more economists become aware of the truth about the origins of the invisible hand and de-couple the modern interpretation from Adam Smith's name, the better it will be for the reputation of the discipline from false doctrinaire myths about how markets work.